Summary of our views is as follows:
∙ The price of money is a significant driver of asset prices and economic activity. This has been the largest, fastest increase in rates ever in the US. We believe the full impacts are still unfolding.
∙ While the rate inflation is clearly declining, we doubt it will return to the very low levels targeted by the Federal Reserve anytime soon. The inputs that kept inflation so low for so long (cheap labor; cheap goods; cheap energy as an input to manufacturing) have all changed.
∙ We caution using a lens from the 2000 – 2021 period as a mechanism to evaluate investments today. A significantly higher price of money, the desire to shrink the Federal balance sheet, and a US Central Bank bias to not cut rates until inflation returns to target, and global protectionism are all reasons why we view the current investing landscape is quite different than the past.
∙ From 1968‐82 the equity market experienced multiple violent rallies and subsequent selloffs, and 70% of purchasing power was lost to inflation. We could see a mini period that is similar ‐> choppy markets with multiple large rallies and declines and steady erosion of purchasing power.
∙ The risk of a credit crunch remains. Investors are no longer willing to accept zero interest from bank deposits and have been reallocating capital into money market funds or other short duration investments. Regional banks have historically been a major provider of CRE, C&I and personal loans. Regional bank business uncertainty could result in tighter lending standards or even an unwillingness to extend credit.
∙ Demand for downside protection in the US equity markets remains anemic. Put option skew remains low, while market liquidity has been on a general downtrend. Don’t underestimate the potential for either a grind lower or a violent downside repricing in equity indices, followed by significantly reduced potential for a rapid recovery in prices as long as the Federal Reserve is unwilling to aggressively cut rates.
Over the past month, a significant number of our contacts have asked what we are doing with stocks and with Commercial Real Estate. So, we have decided to share our outlook and activity with all who read our monthly commentary.
What We Are doing in Equities:
In all of our family office portfolios, our equity exposure is broken into 2 equal parts: Half is allocated to our tactical equity strategies and the other half is allocated to passive (always long) equity positions.
We do this for a very simple reason – we want to modulate exposure in conjunction with market conditions.
This philosophy is rather simple and is quite similar how many of us drive our vehicles on the highway. On warm sunny days, we drive at (or above..) the speed limit and feel safe. But how about on dark nights with heavy snowfall? In those more treacherous conditions, many of us tend to drive with caution, at a much slower pace.
We apply this very same logic to our equity positions – systematically modulating exposure higher when conditions are favorable and lower when conditions are risky.
Our tactical equity positions were generally only 20% invested in early September, and that exposure decreased to a paltry 10% invested by the end of last month. Conditions have remained unfavorable, and thus exposure has been low, which has limited overall equity drawdowns in our portfolios. As conditions improve (as we think they may do in Q4), we expect our systematic equity strategies to increase exposure again.
The new client accounts onboarded after April 2023 were immediately positioned for a full allocation in our tactical equity strategies, but we just couldn’t justify a day 1 full allocation into passive equity positions as well. So for those new accounts, we have held far below target passive equity exposure, and have been increasing that exposure over the past 2 weeks. We are still underweight relative to target, but we are closing the gap as equities decline. The tactical equity positions along with their dialing up and then dialing down exposure allowed us to remain on offense and avoid any FOMO related to the run up in equity prices from May through end July.
What We Are Doing in Commercial Real Estate:
Despite all of the doom and gloom commentary around CRE, we believe now is a great time to be increasing exposure selectively in our favorite markets and property types. The deals we have seen over the past few months have been some of the best of the past 3 years. We still pass on more than 90% of what we see, as deals only fall into 2 categories for us: a no, or a oh hell yes.
For example, our family office portfolios participated in buying a premier piece of land that is currently owned by the US government and is being sold to a private developer. This land constitutes a significant amount of the total waterfront available in the community, and the developer will be constructing a state‐of‐the‐art mixed‐use facility
with retail, restaurants, residential condos, and a waterfront esplanade. The agreed upon purchase price for the property was far below the current appraised value, and some of the critical legacy infrastructure on the property has been grandfathered in despite it being relatively new, but no longer conforming to zoning updates. The project has been broken into 2 distinct phases and we and other family offices that were invited into phase 1 are able to exit with our profits in less than 24 months if we desire, or we can roll any amount of our initial principal and gains into phase 2 which will be more widely distributed to traditional CRE investors. The base case IRR and MOIC on the initial phase is far superior to any multi‐family, industrial or self‐storage investment we have seen in the past few years, and the many downside mitigations embedded in the deal help craft nice asymmetry to the upside on the range of potential outcomes.
These are the types of deals we want to participate in when they (rarely) come along. We will continue to be very choosy, but being nimble with the ability to commit to really special deals when they come along is definitely serving us well.
Monthly Podcast Recommendation:
The Memo by Howard Marks. Further Thoughts on Sea Change
This is a must listen to podcast. Howard discusses how the investment landscape today is very different than the past 20 years, and investors should adjust course.
As a reminder, our Sundial Dynamic All‐Weather Portfolios attempt to achieve positive returns regardless of the macroeconomic regime, such as positive or negative growth, or an inflationary or deflationary environment.
This is achieved through a few key principles:
∙ Utilize multiple asset classes and strategies, beyond traditional equity and fixed income markets ∙ Utilize both active (tactical) and passive (buy and hold) strategies
∙ Recognize that some investments are stability seeking (short volatility bias) and others are instability or dislocation seeking (long volatility bias) and it is critical that a portfolio contains both.
The desired result is a portfolio of non‐correlated revenue streams, that exhibits attractive asymmetry through tactical allocations and return stacking, truncates the downside in adverse markets, and is fully offensive in constructive markets.
Tactical Equity Strategies:
Allocation: High end of the target range
Comment: Our tactical equity strategies have continued to pair back equity exposure over the past month and are mostly in cash, and collecting a healthy short‐term rate of interest while they wait for better conditions. We expect them to engage again when market conditions improve, and since we never know when that period will begin, we let these strategies do what they do best – protect capital from large losses and capture the upside outliers when they appear.
Passive Equity Strategies:
Allocation: Low end of the target range
Comment: Our passive equity longs remain at the low end of our targeted range. These positions are mostly in ETFs and other diversified exposures. We see little reason to tinker with the positions until the macro and central bank outlook is more favorable, as discussed above.
Yield Generating Strategies:
Allocation: High end of the target range.
Comment: A full allocation reflects both our defensive stance and the attractive opportunity set. There are so many strategies that can generate a high single digit and even mid to high double digit annual returns with modest risk. We continue to utilize mostly alternative yield generating investments and our Government and corporate bond exposures are limited to short maturities where yields of around 5% are quite attractive.
Trend Following and Inflation Benefitting Strategies:
Allocation: High end of the target range
Comment: Trend following strategies have performed well over the past month, which is no surprise with the re‐ emergence of the trends higher in rates, lower stocks, and a stronger dollar. We continue to believe the uncertain macro environment continues to be constructive for “dislocation seeking” trend following strategies. Now more than ever, we embrace this uncorrelated stream of returns, particularly as they have the potential to help protect
the overall portfolio if equities resume a downtrend. We were never believers in the stock and bond only portfolio, and we continue to hold the view that owning government bonds will not act as much of a portfolio hedge as long as inflation remains above target. Trend following strategies are a far better portfolio diversifier.
Long Volatility / Long Convexity Strategies:
Allocation: High end of the range
Comment: We continue to maintain maximum exposure to these strategies, and when we take on a new portfolio, this is also one of the first positions we initiate. The cost of tail protection (skew) remains extremely low, the potential for a left fat tail is elevated in our opinion, and we are strong proponents of this exposure in all portfolios.
CHARTS & TABLES:
Even with the recent selloff, there's no rush to buy longer dated Put options.
As prices have made lower lows, the NYSE's McClellan A‐D Oscillator is making a bullish divergence, which says that the energy is going out of the decline. One problem with a divergence, either a bullish or a bearish one, is that it is only a "condition" and not a "signal".
NEGATIVE CORRELATION RIP The negative correlation between bonds and equities that provided a diversification benefit for most of the two decades prior to 2020 has reversed, and investors can no longer rely on a rally in the fixed income side of the portfolio to bail‐out sinking equity positions.
Auto‐loan interest rates are now at their highest since 2008. Meanwhile, the auto loan serious delinquency rates are now at 2008 levels. The average interest rate on a new car loan has nearly doubled in just over 1 year.
Non‐financial corporations are getting a bigger benefit from higher interest income than the drag from higher interest expenses.
This commentary does not constitute an offer to sell any securities or the solicitation of an offer to purchase any securities nor does it constitute tax advice. This information is for informational purposes only and is confidential and may not be reproduced or transferred without the written consent of Sundial. Past performance is not indicative of future results. Statements and opinions in this publication are based on sources of information believed to be accurate and reliable, but we make no representations or guarantees asto the accuracy or completeness thereof. These materials are subject to a more complete description and do not contain all of the information necessary to make any investment decision, including, but not limited to, the risks, fees, and investment strategies of an investment.
This correspondence may include forward‐looking statements. Forward‐looking statements are necessarily based upon speculation, expectations, estimates and assumptions that are inherently unreliable and subject to significant business, economic and competitive uncertainties, and contingencies. Forward‐looking statements are not a promise or guarantee of future events.
Benchmarks and indices are presented herein for illustrative and comparative purposes only. Such benchmarks and indices are not available for direct investment, may be unmanaged, assume reinvestment of income, do not reflect the impact of any trading commissions and costs, management or performance fees, and have limitations when used for comparison or other purposes because they, among other things, may have different strategies, volatility, credit, or other material characteristics (such as limitations on the number and types of securities or instruments) than the Firm. It should not be assumed that your account performance or the volatility of any securities held in your account will correspond directly to any comparative benchmark index. We make no representations that any benchmark or index is an appropriate measure for comparison. The S&P 500® Index is a stock market index from S&P Dow Jones Indices. It is a market capitalization weighted index of 500 of the largest U.S. companies, designed to measure broad U.S. equity performance.
Asset allocation and diversification will not necessarily improve an investor’s returns and cannot eliminate the risk of investment losses. There are no assurances that an investor’s return will match or exceed any specific benchmark.